Month: February 2018

The Federal Reserve is implementing a multi-year interest rate increase plan as a way to manage inflation. Many bull markets have ended as a result of the Federal Reserve raising rates too much.

As long as the 10-year U.S. treasury rate is below 5%, rising interest rates have a positive correlation with a rising S&P 500. Said simply, rates go up and stocks go up. Above 5%, rising rates have a negative correlation with the direction of the S&P 500. Today, the 10-year treasury is about 2.9% — shown with vertical blue dashed line on chart below.

The Federal Reserve attempts to manage inflation (Fed target rate of inflation is 2% year-over-year) through interest rates. By raising interest rates, the Fed can slow economic activity. Borrowing (e.g., for a home or any other purpose) becomes more expensive. Saving and earning interest becomes more attractive. Consumption moderates relieving upward pressure on prices (inflation).
The Fed Funds rate is currently about 1.4%. The Fed says it plans to raise the Fed Funds rate to about 2.7% in 2019. The current spread between the Fed Funds rate and the 10-year treasury rate is about 1.5%. If we assume the spread remains constant going forward, the 2019 10-year treasury rate using the Federal Reserve’s projection of the Fed Funds rate is 4.2%. Based on market relationships dating back 55 years to 1963, interest rates rising should not be a major threat to the bull trend this year.

The 17 consecutive month of positive Leading Economic Index (LEI) percent change month over month was reported this week at plus 1% for January. The LEI continues to signal growth through the first half of 2018.

The chart below shows calendar year S&P 500 returns without dividends (grey vertical bars). Below the bars are red numbers which indicate the maximum intra-year drawdowns. The chart makes clear that 10% drawdowns are fairly common. What is not common is a drawdown of only 3% which was the case in 2017.

Another important observation from the above chart is that as long as the economy is not in a recession (areas shown with horizontal green bars), the calendar year returns are usually positive. The U.S. is not currently in a recession.

From January 1950 through December 2017, the S&P 500 has declined by 5-10% 41 times. The average length of the decline was one month. The average recovery from the low was one month. In the 11 cases that the S&P 500 declined by 10-20%, the sell-off lasted and average of 4 months and recovery took and average of 3 months.

If it wasn’t obvious to investors, fanned the market volatility. Treasury Secretary Steven Mnuchin said that algorithmic trading played a role in the sell-off as he sought to reassure jittery investors.

The S&P 500 fell as much as 9.7% from its peak. That’s practically the definition of a market correction, which is commonly understood to be a decline of at least 10%. The small-cap Russell 2000 did sink more than 10%. (IBD)